Hill Democrats want to raise taxes on the rich. But they are missing the best way to do it.
Taxing the rich is suddenly all the rage among many of the Democratic party’s highest profile politicians. Some favor wealth taxes. Others support a near-doubling of the top tax rate on ordinary income. And most Americans do think the rich are undertaxed. But there is a better, more politically realistic way to address the problem: Tax inherited wealth more efficiently.
Today, we do so very poorly through the estate tax. Only estates above $11.4 million (or twice that for married couples) are subject to the tax that tops out at 40 percent. But the exemption is so large that fewer than 2,000 of the very wealthiest estates will pay it this year, according to Tax Policy Center estimates. And tax planning allows many estates with far more than $22 million to reduce or even escape tax.
Congress could lower the exemption and raise the rate, as Sen. Bernie Sanders (I-VT) has proposed. But in recent decades lawmakers have gone in the opposite direction, consistently raising the exemption. What else could they do?
They could start by no longer giving heirs of large estates a way to avoid tax on trillions of dollars of capital gains.
The problem is a provision of the law called stepped-up basis at death. It works like this: If I bought a share of stock years ago for $10 and sell it today for $100, I will owe capital gains tax on $90. If I bought the same share of stock for $10 and die before I sell it, my heirs are allowed to reset the value (or basis) to the $100 price on day I died. Thus, if they eventually sell for $100, that $90 the stock appreciated over my lifetime is entirely tax free.
Congress could replace this provision with an alternative called carryover basis. Under that method, the cost basis of that share of inherited stock is the same $10 as it was during my lifetime. It is a far better way to tax assets than a direct wealth tax proposed recently by Sen. Elizabeth Warren (D-MA).
Here are a few reasons why:
It is easier to administer. The US already uses carryover basis (or fair market value) for gifts, and the law seems to work relatively smoothly. In the past, critics argued that it was impractical to calculate cost basis for, say, long-held stock or privately-held companies. But third-party reporting and improved technology have made it much easier to figure basis for marketable securities. And while valuing a privately-held business is never easy, it is manageable when assets are transferred—and certainly less complicated than with a wealth tax, where a firm would have to be valued annually.
It is a relatively modest change to existing law. Because carryover basis already applies to gifts, expanding it to estates would be done by adding to the familiar chassis of capital gains taxation. By contrast, a wealth tax is unfamiliar to most Americans. Indeed, Congress adopted carryover basis for estates in 1976, though it delayed and then repealed the change before it took effect. A later voluntary version was in effect—very briefly— in 2010.
It taxes only inherited wealth, not earned wealth. One criticism of a wealth tax is that is does not distinguish between the assets of trust fund babies and those who became rich through hard work and risk-taking. Carryover basis does not directly tax entrepreneurs at all, though it may change their behavior if they are motivated by leaving bequests.
